debt clock

Saturday, April 30, 2011

During the early stages of the housing bubble Morgan Stanley's Stephen Roach was one of the few sane voices on Wall Street. His warnings about the global economy were clear and obviously true, and his willingness to bite the hand that fed him was admirable. The guy had guts. In early 2006 I had the following article all ready to post:

The Bravest Man on Wall Street

People tend to lump the big-name critics of the U.S. economy together, and assume that they're all coming from the same place and somehow benefiting, one way or another, from their points of view. But that's not true. It's relatively easy for a Bob Prechter or Doug Noland or Marc Faber to hold to their positions for years while their truth gradually dawns on the rest of us, because they more-or-less run their own shows. The might lose a few investors, but they don't face institutional resistance from above and below.

That's why Morgan Stanley's Stephen Roach deserves our admiration. He doesn't work for a short seller and he's not the author of best selling gloom-and-doom books. He works for a big, mainstream investment bank, where optimism is golden and pessimism scares clients, lowers trading volumes and eventually gets you fired. To grasp the truth of this you have to understand the internal structure of an investment bank. It's made up of bankers who do deals, traders who trade, and salespeople who convince money managers and other traders to buy the firm's securities. None of these guys likes the idea of a global economic meltdown. In fact they hate sell recommendations in general.

For a salesman, getting a client to buy a given stock or bond builds a relationship and creates an ongoing income stream. At the very least, knowing a customer likes a given security allows the salesman to sharpen the pitch for the next call. On the other hand, if a customer sells everything and goes to cash, that's it. They don't need updates and you have no way of knowing what to offer them by looking at their holdings. Your income goes down, maybe you get fired, and you blame the senior strategist who terrified the money manger into doing this.

It's the same with investment bankers. If investors are selling rather than buying and the overall market is falling, there's no demand for new IPOs. So investment bank economists who predict trouble and aren't immediately proven right tend to be escorted to the door by security.

And yet here's Stephen Roach, coming out every week with some new take on the chaos sure to result from growing global financial imbalances. A couple of years ago he is said to have told a group of Boston money managers that a global meltdown was a near-certainty...

Then, in May of 2006, Roach threw in the towel:

Former bear turns bullish on global economy

The world economy may be able to unwind its current imbalances without serious disruption, Stephen Roach, Morgan Stanley's famously bearish chief economist, predicted on Monday, in a remarkable revision to several years of gloomy prognosis.

Mr. Roach had long warned that the US current account deficit and Asian central banks' ballooning currency reserves risked destabilizing the global financial system.

But on Monday, in a note to clients, he said: "I must confess that I am now feeling better about the prognosis for the world economy for the first time in ages." His comments came as the dollar hit a one-year low against the euro and seven-month low against the yen, as investors remained confident the US Federal Reserve was nearing the end of its interest-rate-tightening cycle.

I sadly filed the blog post away, glad that I hadn't published it just before Roach's apostasy. And over the next couple of years it became clear that this was a sign of a market top. By 2008 the global economy was melting down and Roach was no doubt haunted by visions of the superstar he would have become if he'd only held on a little longer. You don't see that much of him these days.

Now fast-forward to April 2011. The markets are rocking, the risk trade is back on with a vengeance, and bears are suffering through the same death-by-a-thousand-cuts as in 2006. Stephen Roach has been replaced by David Rosenberg, former Merrill Lynch economist and now senior strategist and economist at Gluskin Sheff in Toronto, as the most prominent institutional bear. In clear, well-reasoned reports, he's been predicting doom for the economy and the stock market, only to see everything just keep on rising.

And now he's switched sides:

David Rosenberg Turns Bullish

After trying to call the top in equities every other week for the last two years, David Rosenberg has finally thrown in the towel on the bearish calls. In his Wednesday research report he detailed why he believes equities have achieved a "holy grail" and should continue to move higher:

"On a very near-term basis, and despite my long-standing macro concern list, which has not gone away, it does look like the market is set to rise further. The technicals are suggesting as much, though I do await what Walter Murphy may have to say on the matter. I had said before that a breakout to new highs led by higher volume would be an important technical signpost. Well, we achieved that Holy Grail yesterday - both in level terms and with respect to the change. This is not throwing in the towel, it is an acknowledgment of what the market internals are flashing at the current time from a purely tactical and technical standpoint....

...All that said, we had a breakout to new highs yesterday and this time, the volume rose on the major exchanges, not to mention rising above the 50 DMA on the Nasdaq, which is a clear sign that the big boys are putting money to work. This market continues to impressively climb a wall of worry. Market internals are too strong to ignore right now - the NYSE advancers beat decliners by a 3 to 1 ratio yesterday; the Dow transports soared 1.9%; and the small caps beat their major benchmarks. My overall macro concerns have not gone away, but these market facts on the ground are tough to ignore."

Okay, not exactly an exuberant call for Dow 36,000, but still remarkable after all the gloom and doom Rosenberg has published in the recent past. So is this one of those capitulations at the top that we'll look back on as a signal to mortgage the house and short everything in sight? Who knows? But it sure is interesting...

Thursday, April 28, 2011

Governments are often tempted to live beyond their means. Today, that means national debts and quantitative easing. But a few hundred years ago, it meant debasing coinage.

Silver and gold coins would be 'clipped' - with a tiny quantity of their metal shaved off the edge every time they passed through government hands - or they would be minted with a lower precious metal content than their face value stated. This would enable the monetary authorities to produce more coins for the same amount of bullion, increasing the government's spending power in the marketplace.

The net result was that coins with identical face values did not necessarily hold the same commodity value. And this often led to a rather interesting phenomenon. When people knew there were both 'good' and 'bad' coins floating around, they tended to spend the bad and hang onto the good. Before long, all the good money disappeared into hoards. The only money in circulation was bad money.

This is known as Gresham's Law, named after the sixteenth century financier Sir Thomas Gresham. In its most simple form, Gresham's Law is often stated as "bad money drives out good money", and it's no mere historical curiosity. Gresham's Law is alive and kicking today, nowhere more than in Vietnam.

Vietnam's economy uses three different forms of money today. There is the official currency, the Vietnamese Dong. There is also the US Dollar, which Vietnamese people tend to trust a bit more. And then, there is gold.

Gold is a big deal in Vietnam. The average Vietnamese spends more of each Dollar of income on gold than anyone else on Earth. Total gold buying amounted to 3.1% of GDP last year. (By comparison, private gold purchases amounted to 2.5% of India's GDP, while China's were a mere 0.4%.)

All told, an estimated 500 tonnes of gold - over $24 billion worth - is hoarded away, reckons Huynh Trung Khanh, deputy chairman of the Vietnam Gold Business Council. It's hidden in mattresses and buried in the garden. But gold is not just a store of value in Vietnam. It is also used as a medium of exchange. Which is why, in the day-to-day sense, it also functions as money.

In Vietnam you can put gold in a bank and earn interest. People quote house prices in gold, and pay for them with tael gold bars - each bar weighing approximately 1.2 troy ounces. This makes sense when you consider that Vietnam is a largely cash society. A single property can cost up to 4 billion Vietnamese Dong. That's a lot of paper to count and check.

But if the Vietnamese love their gold, the same cannot be said of the country's central bank. In recent years the State Bank of Vietnam (SBV) has issued several Decrees and Circulars whose combined effect - whether by accident or design - has been to undermine gold's monetary role:

The latest Decree is an attempt to end the practice of banks paying interest on gold (presumably in the hope that people will substitute their gold for paper). Up to now, banks have offered interest on physical gold deposits. They sell the metal on, lend the proceeds as Dong loans and buy an equivalent amount of gold forward from an international bullion bank.

This has been profitable because domestic interest rates have tended to be high enough to cover both the forward rate and the rate they were paying the depositor. Essentially it was a carry trade; borrow gold (from depositors) cheaply, lend at a higher rate.

As of May 1, however, banks will be forbidden to undertake any gold lending activities. And from May 2013 they will have to stop paying interest on gold deposits.

This latter measure may largely be moot by then. As you might expect, with the lending channel blocked, there's no money in it anymore. Gold deposit rates have already fallen sharply.

So why all the rule changes? Well, the authorities see gold as a "bad influence", a destabilizing factor in already messy economic picture.

Consider the following problems afflicting Vietnam:

1.A Large and Growing Trade Deficit - The trade deficit in 2010 was around 12% of GDP. Even worse, it grew wider in the first four months of the year.

3.A Falling Currency - The Dong has been devalued six times since June 2008. Most recently was February 11 this year, when it fell 8.5%.

Sound at all familiar? The way the central bank sees it, the propensity of the Vietnamese to buy gold also makes these problems worse. Gold imports exacerbate the trade deficit (it has no domestic mine output). Buying gold thus weakens the Dong, which puts upwards pressure on inflation. Gold (and indeed Dollar) ownership also undermines the SBV's monetary policy, since its interest rates only apply to the Dong.

But you can hardly blame the Vietnamese people for buying and hoarding gold. Not when the official base interest rate is 9%...high by the near-zero standards of the West, but even worse when you remember that Viet inflation is running at 17.5%.

That means a real rate of return on Dongs of minus 8.5%. By spooky coincidence the exact same percentage by which the Dong was recently devalued.

In this regard, gold ownership is a direct consequence of economic conditions. The only way the SBV could provide Vietnamese with an incentive to save in Dong would be to raise the nominal interest higher than inflation, and thus provide a decent real rate of return. But this would mean rates of around 20% at least. Not only would this hit the domestic economy hard, it would almost certainly cause the Dong to appreciate, which would make the trade deficit even worse.

Unable, therefore, to directly incentivize people the hold paper money, the authorities have resorted instead to marginally disrupting gold's monetary function. But this won't work. People will still prefer to hold gold because the Dong is failing to fulfill one of the core functions of money. It is a terrible store of value.

That is why the Vietnamese continue to hoard "good" money (gold) while passing the bad stuff around. Just as Gresham's Law predicts.

Vietnam is stuck in an inflation-devaluation cycle. Ordinary people do not trust its paper currency, and sell it for something better. This reduces its value against other currencies. It also reduces its value against goods and services, which takes the form of rising consumer prices. All of which serves to make the Dong even less popular...

Could this vicious cycle ever strike the US Dollar, British Pound, or the Euro? Maybe it's already begun. Gold and silver prices have risen strongly over the last decade in all those currencies, and especially versus the Dollar so far in 2011. This tells us that many Westerners - just like the Vietnamese - are keen to swap their paper for metal.

If the Dollar and its paper cousins continue to leak value, many more cash savers could look to join them.

Tuesday, April 26, 2011

Winston Churchill once said "that for a nation to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle." It could be said with equal certainty that printing and spending money as a path to prosperity falls into the same category.

Unfortunately, it seems the only consistent skill governments and central banks possess is the ability to debauch their currencies. They have an unblemished track record in this regard as evidenced by the uniform collapse in the purchasing power of fiat money since modern central banking came into widespread existence in the early part of the 20th century - witness the greater than 95% decline in purchasing power in both the US and Canada as an example of massive and unrelenting central bank inflation.

Granted, pointing out the role of governments and central banks in inflation is not a novel observation. Many have made this connection before and much more elegantly including Ludwig von Mises who said "Government is the only institution that can take a valuable commodity like paper and make it worthless by applying ink" and Voltaire, a man who lived through a spectacular fiat money collapse, who said that "paper money eventually returns to its intrinsic value - zero."

So you might reasonably ask what is the point of this note if I'm going to state the obvious?

There is much talk about QE, stimulus, bond yields, risk premiums, volatility, velocity of money, deflating asset prices and so on and so on. My point today is that to focus on what is happening in the immediate term is to miss the forest for the trees. Only by taking a step back is it possible to remember that the developed world is still in the midst of a truly massive and unprecedented experiment in which the Keynesians are still in charge - printing and dispensing money on a vast scale. Some say that it will have no effect because the "velocity of money has collapsed" while others predict hyperinflation.

In the midst of all the seemingly contradictory data and the clearly contradictory predictions I prefer to fall back on a simple economic dictum - if an item can be created for zero cost and is created in increasing quantities its value will trend to zero. Is money subject to different rules than other economic goods?

That leads directly to my next question - will the governments of the west continue to print money? Morgan Stanley thinks yes. In a recently published research piece proclaiming the US "broke" and that no conceivable combination of austerity and/or tax increases will fix the problem, Morgan predicted that some form of default via the printing press is sure to happen. Societe Generale went a step further and conducted a simple calculation of the approximate "net worth" of various western governments. To use SocGen's circumspect language "the fiscal challenges are unprecedented". More specifically SocGen concluded that Italy, Germany, France, Portugal, United States, United Kingdom, Spain, Ireland and Greece all have large negative net worths - i.e. they are bankrupt. Canada wasn't mentioned, not because the government's finances aren't in the same dismal condition, but because SocGen didn't publish the numbers.

It is the unfolding bankruptcy of western governments that will drive inflation as they increasingly rely on the printing presses to fund their deficits. Jordan Roy-Byrne reminds us "Hyperinflation is a fiscal not a monetary phenomenon. The reality is that hyperinflation is first and foremost set in motion and driven by a deteriorating fiscal situation. In fact, significant economic weakness and deflation is a precursor to hyperinflation. Too many analysts believe that there has to be some economic demand or some consumption to stimulate inflation or hyperinflation. Printing money to try and stimulate your economy or excessive credit growth is what leads to inflation. Printing money because you are broke and can't service your debts is what leads to hyperinflation."

To follow the logic to it's conclusion, if the governments of the west are bankrupt isn't a printing press default plausible? Time will tell, but I feel certain about this - the governments of the world can't print food and can't print energy but they can and will continue to print money. Therefore I want to leave you with three simple questions - in the next decade will:

■Fiat money be worth more or less

■Energy demand be higher or lower

■Food demand be higher or lower

If you believe as I do that fiat money will be worth less while food and energy demand will be significantly higher then perhaps you will appreciate the logic of having long term, low cost exposure to the things that the growing economies of the world need (food and energy) but located in politically stable parts of the world like western Canada.

Monday, April 25, 2011

Despite the belief shared by many that economists are heartless, helping the poor has been at the center of economics from the very beginning. Really, at its core, the discipline works to understand and explain the reasons for wealth gaps between countries and between individuals. Adam Smith even named his book An Inquiry into the Nature and Causes of the Wealth of Nations, in order to provide a sort of an (institutional) recipe for achieving wealth and to show why some countries are successful and others are not. This is no different today, as Nobel Prize winning economist Robert Lucas has said, “Once you start thinking about economic growth, it is hard to think about anything else.” In other words, the main motivation of economics is to explain the reasons that make the whole world better off.

This leads to the question: why the misconception that economists are heartless? I believe the answer has to do with emotions. The suffering of human beings, no matter who they are, is no laughing matter. This is just another reason that solutions need to be looked at calmly, coolly, and objectively. We need to find the correct solutions and this requires checking your emotions at the door.

Humanitarians seem to become too attached to their stance at an emotional level, even seeming to suffer from a mystical belief in the moral superiority of their solutions, no matter what the outcome. In fact, this has led to the enactment of countless terrible public policies. Economics, on the other hand, is a science. The economist’s job is to take the end as given and then explain the best ways to achieve that end.

For example the issue of sweatshops is one of the most emotional issues, which enrages many Americans today. People see struggling women and children “forced” to work in terrible working conditions and call: “Sweatshops must be Stopped!” “Ban them!” “We must boycott!” The question is: will closing sweatshops stop “exploitation” and get people out of poverty?

Many economists argue that these solutions would have detrimental effects on the poor.

Today’s document is the Cliché of Socialism Number 40 by Paul L. Poirot, in which he correctly argues why the labor laws put in place to prevent child labor and improve working conditions are not responsible for ending sweatshops in the United States. That kind of labor was necessary at one time, but as wealth was accumulated, this type of labor became undesired and went away. In fact, laws banning sweatshops, if put in place at that time, would have done more harm than good and would not have achieved the desired ends. Paul Poirot is not alone; many economists point that there are some positive benefits of sweatshops for the poor. One of these economists is Professor Benjamin Powell.

“Positive benefits! Outrageous, would you want to work in a sweatshop?” Of course not, none of us would, if given the right choice, but sweatshops are not the problem, poverty is. Poverty creates a situation where sweatshops might just be the best option given all other alternatives. When we step back and look at the problem objectively this becomes clear. First, there is no magic solution to quickly eliminate poverty but with the right institutions in place individuals will have incentives to create and foster economic growth. Second, opportunity costs matter. If you take away sweatshops, what will these workers do? Well, many will be “forced” to work in much worse and less paying jobs, some (perhaps even children) may resort to prostitution, others may simply starve to death. If sweatshops create slavery it would be another matter, but the fact is this: given all opportunities and constraints these individuals want to work in the sweatshops. As workers become wealthier competitive forces improve working conditions, increase wages, create more leisure, etc. So, they can enjoy the same benefits, us people living in wealthy countries enjoy today. There is no quick path to this point and wealth must be built up.

Once humanitarians acknowledge this fact, the right response should be to encourage trade with countries where sweatshops exist. Buy sweatshop goods, higher demand for their services means the quicker wealth accumulation by these workers, which inevitably will lead to disappearance of sweatshops. Restricting trade with countries where sweatshops still exist keeps these individuals poor, which is the opposite of what we want.

Friday, April 22, 2011

By Wayne Allyn Root, Former Libertarian Vice Presidential Nominee and Author of “The Conscience of a Libertarian”

Only days ago, Howard Dean gave a speech where he insinuated that anyone who says “Obama is a Socialist” is crazy, ignorant, racist, or extreme. Funny, a recent national poll shows that a majority (55%) of Americans believe “Socialist” best describes Obama. Another poll shows the Democrat Party is filled with people who identify with Socialism. I say, it’s time for them to come out of the closet.

I ought to know. I was Obama’s college classmate at Columbia University Class of ’83. Our college was dominated by Socialists and Marxists who hated capitalism and America. Let’s look at the facts up close and personal- Jeff Foxworthy style. Foxworthy leaves no doubt as to “who might be a redneck.” Let me leave no doubt that “Obama might be a Socialist.”

If you believe it's greedy for American taxpayers to want to keep more of their OWN money…but not greedy to demand government confiscate other people’s money and redistribute it to those who didn’t earn it…YOU MIGHT BE A SOCIALIST.

If you don’t understand (or care) that babies scream and cry the moment they are born because they are already heavily in debt and facing a bleak future and lower quality of life…YOU MIGHT BE A SOCIALIST.

If the only thing you, your cabinet members, and czars know about business is from books read at Harvard Law School...written by Karl Marx…YOU MIGHT BE A SOCIALIST.

If you want to allocate hundreds of millions to the IRS, to go after tax cheats when your administration is filled with tax cheats…including the guy in charge of America's taxes (Treasury Secretary Timothy Geithner)...YOU MIGHT BE A SOCIALIST.

If you think the “White House Party Crashers” are terrible people because they came to a state dinner without an invitation, but you want to give instant citizenship to twelve million uninvited “illegal aliens” who crashed our border…YOU MIGHT BE A SOCIALIST.

If you think anyone who doesn't read the New York Times is dumb and ignorant...but think it's okay for Congress to pass a 2000 page healthcare bill without reading it...YOU MIGHT BE A SOCIALIST.

If you think Times’ columnist Paul Krugman deserves a Nobel Prize for economics and you deserve a Nobel Peace Prize even though neither of you created a job or ended a war…YOU MIGHT BE A SOCIALIST…AND AN IDIOT TOO.

If you think it's okay to meet with dictators, bullies, tyrants and terrorist sympathizers without preconditions, but have no interest in meeting with conservatives in Congress...YOU MIGHT BE A SOCIALIST.

If you think it's okay to give Constitutional rights to terrorists…but not to the bondholders, shareholders and secured creditors of GM & Chrysler when you stole the company from them and awarded it to the unions that bankrupted them ...YOU MIGHT BE A SOCIALIST.

If you think Raul Castro, the leader of communist Cuba, firing 500,000 government employees by telling them "government can no longer employ or take care of everyone"…isn’t a hint that perhaps America needs to reduce our obscene number of government employees…YOU MIGHT BE A SOCIALIST.

If you think Bush’s spending was an embarrassment, a travesty, and a sin…but you have no problem increasing the national debt more in one day than the entire 2007 budget deficit…YOU MIGHT BE A SOCIALIST…AND HYPOCRITE TOO.

If you think Whoopi Goldberg and Joy Behar of “The View” represent the moderate wing of the Democrat Party…YOU MIGHT BE A SOCIALIST.

If you think it was okay for Nancy Pelosi to pass Obamacare so she could benefit from the special clause on page 1,890...that gives free facelifts to public officials...YOU MIGHT BE A SOCIALIST. (Just kidding!)

If you want to convert America to a “green economy” to create jobs…after Spain has proven the green economy destroys three times as many jobs as it creates and leads to 20% unemployment…YOU MIGHT BE A SOCIALIST.

If you think denying someone a job, government contract, or entry to college because of the color of their skin is immoral and criminal…but GIVING someone a job, government contract, or college admission because of a different color of their skin is “social justice”…YOU MIGHT BE A SOCIALIST…AND A RACIST TOO.

If you want to abandon capitalism and put the economy under the control of government bureaucrats, even though virtually every city, county, state and federal department run by these same bureaucrats is insolvent and bankrupt...YOU MIGHT BE A SOCIALIST.

If you favor taxpayer bailouts of companies who give you campaign contributions…and hide it by refusing to disclose who got the money, or how much…and you demand your cronies in Congress pass the 1000+ page bailout bill without reading it...YOU MIGHT BE A SOCIALIST…AND A FASCIST TOO.

If you think spending an extra trillion dollars will SAVE money on healthcare and reduce the deficit...YOU MIGHT BE A SOCIALIST…AND I’M BETTING YOU LEARNED YOUR MATH IN PUBLIC SCHOOL.

If your solution to Medicare driving the country into bankruptcy is expanding it to everyonewith Obamacare…YOU MIGHT BE A SOCIALIST...AND I'M BETTING YOU FLUNKED OUT OF PUBLIC SCHOOL.

If want to lower the cost of healthcare…but left out "Tort Reform"...YOU MIGHT BE A SOCIALIST LAWYER.

If you're a Columbia University professor...and gave a student named Barack Obama an “A” in economics…YOU ARE DEFINTELY A SOCIALIST…AND SHOULDN’T BE TEACHING ECONOMICS TO ANYONE.

And finally, in the 8th year of the Obama Presidency, if Bangladesh is hosting “Aid America” concerts, or you’re standing in line for toilet paper…YOU HAVE A SOCIALIST PRESIDENT.

It was 101 years ago on April 12, 1910, that William Graham Sumner died. He had been born nearly 70 years earlier on October 30, 1840, almost 30 years to the day before the birth of another American libertarian, Albert Jay Nock, whose career bears a striking, if superficial, similarity to Sumner's. Like Sumner, Nock began his career, while still in his 20s, as an Episcopal clergyman. Like Nock, Sumner went into such work largely to please his family. But the job was a poor fit for both men. Nock walked away from it after little more than a decade. Sumner didn't make it even five years.

Both men moved on directly from religious employment to the work for which they came to be best known: Nock, at the age of 40, moved on to the magazine journalism for which he became famous in the 1920s and '30s; Sumner, while still in his early 30s, moved on to a position as professor of political economy at Yale, which he held for the rest of his life.

Today neither Nock nor Sumner is particularly well known, and those who do know of Sumner (those who don't confuse him with Charles Sumner, the abolitionist senator from Massachusetts) probably know him as a "social Darwinist." And this is ironic, for he was not so known during his lifetime or for many years thereafter. Robert C. Bannister, the Swarthmore historian, edited a valuable collection of Sumner's essays nearly two decades ago for Liberty Fund. This is how he describes the situation in his foreword to that volume: "Sumner's 'social Darwinism,'" he writes, "although rooted in controversies during his lifetime, received its most influential expression in Richard Hofstadter['s] Social Darwinism in American Thought," which was first published in 1944.

In fact, there is considerable evidence that the entire concept of "social Darwinism" as we know it today was virtually invented by Richard Hofstadter. Eric Foner, in an introduction to a then-new edition of Hofstadter's book published in the early 1990s, declines to go quite that far. "Hofstadter did not invent the term Social Darwinism," Foner writes, "which originated in Europe in the 1860s and crossed the Atlantic in the early twentieth century. But before he wrote, it was used only on rare occasions; he made it a standard shorthand for a complex of late-nineteenth-century ideas, a familiar part of the lexicon of social thought." In the process, he not only portrayed William Graham Sumner as a "social Darwinist"; he also portrayed Herbert Spencer that way. In fact Richard Hofstadter seems to be the principal source of the widespread modern belief that both these men were "social Darwinists."

But were they? What precisely is this "complex of late-nineteenth-century ideas," as Eric Foner puts it, that the phrase "social Darwinism" is supposed to stand for? Perhaps the most frustrating thing about doing a little general reading in this field is discovering how difficult it is to find any sort of definition of that phrase — "social Darwinism" — especially if one is hoping to find a succinct and quotable definition of it. Entire books are written on the subject without ever carefully and clearly delimiting exactly what that subject is. In essence, however, "social Darwinism" seems to be the notion that success in the market proves an individual's fitness to survive in the struggle for existence, so that both legislation and private charity meant to assist those who fail in the market are inadvisable, since our species will grow stronger if these "unfit" individuals are allowed to die off.

Herbert Spencer (1820–1903)Did anyone ever espouse this doctrine? Herbert Spencer certainly didn't. Spencer, who was born 191 years ago on April 27, 1820, was an enthusiastic exponent of evolution, true enough. In fact, he wrote about evolution before Darwin did. In fact, it was Herbert Spencer, not Charles Darwin, who coined the phrase "survival of the fittest." But Spencer was no sort of Darwinian at all. Even after Darwin began publishing, Spencer remained a Lamarckian, a disciple of an earlier advocate of evolution who believed organisms could pass on acquired characteristics to their offspring. In the case of humans, Spencer's view was that culture and education made this process possible. Also, Spencer was a proponent of private charity.

Was William Graham Sumner an advocate of "social Darwinism"? As I have indicated, he has been so described, most notably by Richard Hofstadter and various others over the past 60-odd years. Robert Bannister calls this description "more caricature than accurate characterization" of Sumner, however, and says further that it "seriously misrepresents him." He notes that Sumner's short book, What Social Classes Owe to Each Other, which was first published in 1884, when the author was in his early 40s, "would … earn him a reputation as the Gilded Age's leading 'social Darwinist,'" though it "invoked neither the names nor the rhetoric of Spencer or Darwin."

It is interesting, in fact, to take a look into its pages and see what it is exactly that What Social Classes Owe to Each Other does propound. Below are some passages that I think fairly represent the book's central concerns and propositions.

One of those concerns was the history of human civilization, particularly its political component. "The history of the human race," Sumner wrote, "is one long story of attempts by certain persons and classes to obtain control of the power of the State, so as to win earthly gratifications at the expense of others." All this began, according to Sumner, "in ancient times [when] organized bands of robbers … plundered laborers and merchants," until, eventually, "they found that means of robbery which consisted in gaining control of the civil organization — the State — and using its poetry and romance as a glamour under cover of which they made robbery lawful."

By "the civil organization," here, Sumner seems to mean whatever local or tribal organization provided the bundle of services — community defense, adjudication of disputes, identification and apprehension of wrongdoers — that Albert Jay Nock called "government." The bands of robbers took over the local government and transformed it into a state. And, of course, "they developed high-spun theories of nationality, patriotism, and loyalty" to justify these nefarious deeds in the minds of their victims.

Since then, Sumner wrote, human history has been "only a tiresome repetition of one story. Persons and classes have sought to win possession of the power of the State in order to live luxuriously out of the earnings of others." Yet,

the fashion of the time [Sumner is referring here to the 1880s] is to run to Government boards, commissions, and inspectors to set right everything which is wrong. No experience seems to damp the faith of our public in these instrumentalities. The English Liberals in the middle of this century seemed to have full grasp of the principle of liberty, and to be fixed and established in favor of non-interference. Since they have come to power, however, they have adopted the old instrumentalities, and have greatly multiplied them since they have had a great number of reforms to carry out. They seem to think that interference is good if only they interfere. In this country the party which is "in" always interferes, and the party which is "out" favors non-interference.

"Men who are taught to expect Government

inspectors to come and take care of them

lose all true education in liberty."

William Graham SumnerI found it startling after reading that passage to be reminded that Sumner was writing here about the Republican and Democratic parties as they were 130 years ago. Little wonder that, as Robert Bannister tells us, Sumner had experienced "disillusionment with politics" as early as 1877 and had "repudiated politics as a waste of time" by 1880, "declining even to vote" in that year's presidential election.

There were, Sumner said, only "two notions" to choose from in making political decisions. One was the notion that the state should "regulate things by a committee of control, and the other to let things regulate themselves by the conflict of interests between free men." These two notions, he said, "are diametrically opposed; and the former is corrupting to free institutions, because men who are taught to expect Government inspectors to come and take care of them lose all true education in liberty."

The bottom line, according to Sumner was that "if we have been all wrong for the last three hundred years in aiming at a fuller realization of individual liberty, as a condition of general and widely diffused happiness, then we must turn back to paternalism, discipline, and authority; but to have a combination of liberty and dependence is impossible." In fact, of course, Sumner didn't believe for a moment that "we have been all wrong for the last three hundred years." He did believe, however, that in a free society it is not the state that holds people together. Rather

the ties by which all are held together are those of free co-operation and contract. If we look back for comparison to anything of which human history gives us a type or experiment, we see that the modern free system of industry offers to every living human being chances of happiness indescribably in excess of what former generations have possessed. It offers no such guarantees as were once possessed by some, that they should in no case suffer. We have an instance right at hand. The Negroes, once slaves in the United States, used to be assured care, medicine, and support; but they spent their efforts, and other men took the products. They have been set free. That means only just this: they now work and hold their own products, and are assured of nothing but what they earn. In escaping from subjection they have lost claims. Care, medicine, and support they get, if they earn it. Will anyone say that the black men have not gained? Will anyone deny that individual black men may seem worse off? Will anyone allow such observations to blind them to the true significance of the change? If anyone thinks that there are or ought to be somewhere in society guarantees that no man shall suffer hardship, let him understand that there can be no such guarantees, unless other men give them — that is, unless we go back to slavery, and make one man's effort conduce to another man's welfare.

Sumner believed that if the question at hand was What Social Classes Owe to Each Other, we should find the correct answer by focusing, not on social classes at all, but on individuals. "Every man and woman in society," he wrote,

has one big duty. That is, to take care of his or her own self. This is a social duty. For, fortunately, the matter stands so that the duty of making the best of one's self individually is not a separate thing from the duty of filling one's place in society, but the two are one, and the latter is accomplished when the former is done. The common notion, however, seems to be that one has a duty to society, as a special and separate thing, and that this duty consists in considering and deciding what other people ought to do. Now, the man who can do anything for or about anybody else than himself is fit to be head of a family; and when he becomes head of a family he has duties to his wife and his children, in addition to the former big duty. Then, again, any man who can take care of himself and his family is in a very exceptional position, if he does not find in his immediate surroundings people who need his care and have some sort of a personal claim upon him. If, now, he is able to fulfill all this, and to take care of anybody outside his family and his dependents, he must have a surplus of energy, wisdom, and moral virtue beyond what he needs for his own business. No man has this; for a family is a charge which is capable of infinite development, and no man could suffice to the full measure of duty for which a family may draw upon him. Neither can a man give to society so advantageous an employment of his services, whatever they are, in any other way as by spending them on his family. Upon this, however, I will not insist. I recur to the observation that a man who proposes to take care of other people must have himself and his family taken care of, after some sort of a fashion, and must have an as yet unexhausted store of energy.

Such energetic do-gooders would do well to attend to the potential downside of what they are undertaking, however, for, as Sumner put it,

the danger of minding other people's business is twofold. First, there is the danger that a man may leave his own business unattended to; and, second, there is the danger of an impertinent interference with another's affairs. The "friends of humanity" almost always run into both dangers. I am one of humanity, and I do not want any volunteer friends. I regard friendship as mutual, and I want to have my say about it. I suppose that other components of humanity feel in the same way about it. If so, they must regard anyone who assumes the role of a friend of humanity as impertinent. The reference to the friend of humanity back to his own business is obviously the next step.

Yet we are constantly annoyed, and the legislatures are kept constantly busy, by the people who have made up their minds that it is wise and conducive to happiness to live in a certain way, and who want to compel everybody else to live in their way. Some people have decided to spend Sunday in a certain way, and they want laws passed to make other people spend Sunday in the same way. Some people have resolved to be teetotalers, and they want a law passed to make everybody else a teetotaler. Some people have resolved to eschew luxury, and they want taxes laid to make others eschew luxury. The taxing power is especially something after which the reformer's finger always itches. Sometimes there is an element of self-interest in the proposed reformation, as when a publisher wanted a duty imposed on books, to keep Americans from reading books which would unsettle their Americanisms; and when artists wanted a tax laid on pictures, to save Americans from buying bad paintings.

There was one other duty Sumner believed the individuals in society owed to each other. And it was rather an odd one for a "social Darwinist" like him. He thought people owed each other compassion and assistance. "We may philosophize as coolly and correctly as we choose about our duties and about the laws of right living," Sumner wrote;

no one of us lives up to what he knows. The man struck by the falling tree has, perhaps, been careless. We are all careless. Environed as we are by risks and perils, which befall us as misfortunes, no man of us is in a position to say, "I know all the laws, and am sure to obey them all; therefore I shall never need aid and sympathy." At the very best, one of us fails in one way and another in another, if we do not fail altogether. Therefore the man under the tree is the one of us who for the moment is smitten. It may be you tomorrow, and I next day. It is the common frailty in the midst of a common peril which gives us a kind of solidarity of interest to rescue the one for whom the chances of life have turned out badly just now. Probably the victim is to blame. He almost always is so. A lecture to that effect in the crisis of his peril would be out of place, because it would not fit the need of the moment; but it would be very much in place at another time, when the need was to avert the repetition of such an accident to somebody else. Men, therefore, owe to men, in the chances and perils of this life, aid and sympathy, on account of the common participation in human frailty and folly.

Sumner cautioned his readers that he believed the duty to provide aid and sympathy to others belongs "in the field of private and personal relations, under the regulation of reason and conscience." He didn't believe the existence of this duty justified any sort of state guarantees against hardship.

What Social Classes Owe to Each Other contains much more of interest to modern libertarians, including one of the best simple, popular discussions you'll find before the 1940s of the importance of capital to civilization. It's a treasure of the libertarian tradition, and I recommend it wholeheartedly.

Perhaps Richard Hofstadter should have read it before he called William Graham Sumner a "social Darwinist."

Thursday, April 21, 2011

I was looking at some IRS numbers on who pays taxes to the federal government. This data is from 2008. That was a bad year to look at incomes/taxes. There was a big drop in income due to the recession and market crash. But it’s still useful to look at.

If we’re going to raise any significant amount of new revenue it will have to come from the top 5% of earners. Note that in 2008 the top 5% was anyone who made over $159k. That number has crept up in the last few years. For 2012 the top 5% will be any household income that is in excess of ~$170k. Depending on where you live and how big your family is that is really not so much these days. But it is greater than the rest of the 95%, so that is where the new taxes will have to fall.

Note in 2008 the top 5% (a) earned 35% of all income, (b) paid $600 billion in taxes, (c) paid 59% of all taxes, and (d) the average tax rate was 21%.

I think the AGI revenue numbers are currently running at ~$9.2T (up 10% since 2008). Assume that the effective tax rate is about the same. Now let’s raise the taxes on this group of rich people. How much more should they pay? How does a 50% increase strike you? Changes in the tax code to limit deduction AND increase the top bracket that resulted in an increase from 20% to 30% it would raise an additional $325billion. With a 1.6 trillion deficit that extra money would come in handy, but it only covers 20% of that shortfall.

If the tax rate(s) were to be adjusted so that the poor bastards who are making over $170k get their taxes doubled from 2008 levels it would still only raise $625b, leaving us with a hole of $1 trillion.

The effective tax rate would have to be raised on the entire top 5% to 75% in order to balance the budget. Put another way; if you were lucky enough to earn $200k, your take home would only be $50k. And that number does not include state taxes, property taxes or sales taxes. Basically, you have nothing left.

If you think that the solution is to raise taxes BIG TIME on the uber-rich, think again. The top 1% should have about $1.85T in income in 2012. IF we really sock it to them and nailed them at a 90% effective rate we could cover 1.3T of the 1.6 shortfall. This would imply that the top 1% would be paying 75% of all taxes collected.

I hope that this shows that raising taxes on wealthy Americans does not work very well. Yes, we could technically go the route of Sweden and tax income over $500k at 70% or so. But what might be the consequences?

Question: What should the federal rate on high-income earners be? What rate would you apply to those making ¼ mil a year or more? ½ mil? A cool mil?

It began with a shoot-out at the Circle K Ranch. The 12 best marksmen would ride shotgun as the world’s largest, privately owned stockpile of silver was secretly transferred into secure vaults.

No, this wasn’t a shipment from Nevada’s Comstock Lode to San Francisco in the Wild West of the 1870s. This was the 1970s, and the precious metal was being moved from New York to Switzerland.

Shining silver under a moonlit sky, three unmarked 707s waited at LaGuardia Airport. The Circle K cowboys stood guard, shotguns in hand. 40 million ounces of bullion – amassed by Nelson Bunker and William Herbert Hunt – were loaded in, and the planes took off under cover of darkness to their secret destination…

Millions of people have heard the “official” story of how the larger-than-life Hunt brothers drove the price of silver from under $2 an ounce to over $50 in an attempt to corner the market. At one point, the two colorful Texas oilmen owned the rights to more than half the world’s silver supply. But then it all came crashing down on Silver Thursday, March 27, 1980, when silver fell to under $11 an ounce. Instead of making billions, the richest men in America ended up losing the bulk of their family’s fortune.

The Hunt Brothers—Sacrificial Lambs in Wolf’s Clothing

I’ve been studying the Hunt Brothers, and I have a different take on what really happened. Because of the way they flaunted their wealth, because of ties they had to the Middle East, and because they did invest so heavily in silver, the Hunt brothers were the perfect scapegoats for the anger and frustration most Americans felt towards the lagging economy of the day.

I believe that Bunker and his brother were used by the Federal Reserve, in collusion with Comex and the Chicago Board of Trade (CBOT), to cap the price of gold—yes, gold—and save the US dollar.

Inflation Indignation

The period leading up to silver’s spike was fraught with inflation, stagnant economic growth, and political upheaval. In 1965, President Johnson increased deficit spending to finance his Great Society programs, tax cuts, and an unpopular war in Vietnam.

In 1971, realizing that the US Treasury didn’t have enough gold to redeem all the dollars held by foreign governments and investors, President Nixon pulled the United States off the Bretton Woods monetary system – the last vestiges of a pseudo gold standard. This action effectively created a worldwide fiat currency system that continues to this day.

OPEC-generated oil shortages, along with real food shortages, fueled public fears that the US economy was in crisis. By the late 1970s, inflation had become public enemy number one.

The Hunt for Silver

The Hunt brothers could see the writing on the wall. With their great wealth being steadily eroded by skyrocketing inflation, they needed an asset to which they could safely anchor their massive oil fortune. At first, they thought of gold – history’s safe haven. But in 1973, US citizens were not allowed to own gold, and Bunker Hunt thought the gold market was too easily manipulated for government purposes.1

So the Hunt Brothers turned to silver, and started buying it at about $2 an ounce. Total world silver production was dropping, while industrial silver consumption was exploding. And once government and private silver stocks ran out, the shortfall between supply and demand was certain to drive the price of silver skyward.

By early 1974, the Hunt brothers had purchased futures contracts (agreements to purchase commodities in the future at a pre-determined price) for another fifty-five million ounces of silver. This was on top of the massive hoard of physical silver they already owned.2 In April, Bunker Hunt stopped in New York to visit the Comex trading floor for the first time. When he walked onto the floor, the normal frenzy of activity came to a screeching halt. Who was this fat Texan in thick plastic glasses and a cheap blue suit? Rumors began floating that the Hunt brothers were attempting to corner the market.

Those who believe that the Hunt brothers were out to corner the silver market point to Bunker and Herbert’s huge appetite for silver futures as proof that they were trying to manipulate prices. I see it a different way.

The Hunt brothers used their positions in silver futures to acquire more of the physical metal. Aware that cash was continually losing value due to inflation, they settled their futures contracts with physical delivery of bullion, instead of cash, as a hedge against the government currency monopoly and global turmoil.

I believe that the Hunt brothers were more concerned about long-term survival and preservation of their family’s wealth than they were with short-term speculative profits. That would merely have added a few more paper dollars to their vast sums of rapidly depreciating currency. Bunker Hunt was well versed in Germany’s disastrous hyperinflation of the early 1920s, and he was genuinely concerned about going broke holding paper assets.

In an interview with Barron’s financial magazine, Bunker kept quiet about his silver investments. But he made no secret of his distaste for the dollar: ‘‘Just about anything you buy, rather than paper, is better,” he said. “…If you don’t like gold, use silver, or diamonds or copper, but something. Any damn fool can run a printing press.”3

If You’re Losing, Change the Rules

By October 3, 1979, silver hit $17.88 an ounce.4 The two major US exchanges, Comex and CBOT, started to panic: They held a measly 120 million ounces of silver between them, an amount typically delivered in a busy month.5 With silver prices pushing to new heights as new buyers rushed in, the exchanges became fearful that a default (inability to deliver) was imminent.

The silver rush continued to accelerate, led by the Hunt brothers and their Saudi Arabian business partners. The Commodity Futures Trading Commission (CFTC), the government’s futures watchdog, had become seriously alarmed at the prospects of a shortage on the exchanges, and tried persuading Bunker Hunt to sell some of his silver.

The billionaire resisted, believing that silver was a long-term play with an integral role in the future global economy. The CBOT, backed by the CFTC, finally decided to put a stop to the Hunt brothers’ buying – by changing its rules.

Margin requirements were suddenly raised, and traders could hold no more than 3 million ounces of silver futures; those holding more were placed in forced liquidation. Bunker Hunt cried foul, accusing exchange board members of having a financial interest in the markets – an accusation that would later be proven true.

Then, the US Federal Reserve and its chairman, Paul Volcker, added to the Hunt brothers’ troubles by strongly encouraging banks to stop making loans for speculative activity.

When Silver Sneezed, Gold Caught the Cold

On January 7, 1980, the other major US exchange, Comex, changed its rules also. Investors were limited to 10 million ounces in futures contracts, and any amount above that had to be liquidated by Friday, February 18.6 On the very next trading day, Monday, January 21, as silver reached a record high of $50 an ounce, the Hunt silver hoard peaked at a mind-boggling $4.5 billion, (that’s $43.5 billion in Shadowstats CPI-adjusted 2011 dolars!)5

On the same day that silver hit $50 and silver futures topped out at $52.50, gold’s price set a new record of $850 and gold futures peaked at $892. Comex, terrified that it would be forced into default, announced – with the backing of the CFTC – that trading in silver would be limited to liquidation orders only, eliminating any buyers.

With no new buyers, the price of silver could not go up. So this rule was basically the same as saying, “Until this rule is lifted, the price of silver will only go down.” Of course, silver began to plummet, and on that same day so did gold.

Was it just a coincidence that gold and silver peaked at the same time?

Could it be that many large silver traders also held gold?

Wouldn’t the gold traders on the exchanges have known what happened to the silver traders and said to themselves, “Oh my God…if they can do that to silver, then gold is probably next”?

From Billions to Bust

On Silver Thursday, silver dropped from $15.80 to $10.80 an ounce. The stock market also crashed, fueled by rumors that the Hunt brothers would liquidate stocks in order to cover their silver losses. Because most of their silver bullion had been purchased at under $10 an ounce, the Hunts were still ahead of the game on their physical silver. But in the futures market, where their average purchase price was near $35 an ounce, it was a different story.

It became easy for the government to label the Hunt brothers as market manipulators – both in the court of law and in the easily swayed court of public opinion. Bunker Hunt filed for personal bankruptcy and was charged with trying to corner the silver market. He settled with the IRS for $90 million and was fined an additional $10 million by the CFTC.7

Why were the Hunt brothers torn down? Gold and silver are the canaries in the coal mine: Their spiking prices reflected the public’s loss of confidence in fiat currencies – like the US dollar. So, the government and banking establishment had a vested interest in keeping gold and silver prices from exploding.

Do you think it’s possible that the Federal Reserve may have realized they could suppress the price of gold and save the dollar – while making it look like they were really protecting everyone by going after the Hunt brothers?

After scrutinizing the evidence, my conclusion is that the Hunt brothers were sacrificial lambs. The Hunt brothers broke no laws. The CFTC, Comex and CBOT simply changed the rules in the middle of the game. And the US government, eager to stop the rush to gold and silver that threatened the credibility of its own fiat currency, had no problem looking the other way.

Even Jeffrey M. Christian, managing director and founder of CPM Group and one of the world’s foremost authorities on the markets for precious metals, told me in an interview that he believed the Hunt brothers only added between 75¢ and $1.00 to the price of silver.

Silver Linings: What the Hunt Brothers Can Teach Us Today

The Hunt brothers got into trouble because they exposed themselves to a huge amount of risk through their leveraged investments. Leverage makes a bigger impact when you’re losing than it does when you’re winning: It can be as blunt as a bowling ball on the way up, but as sharp as a surgical laser on the way down.

In my view, there’s simply no substitute for physical ownership of your own gold and silver. This is especially important today, as we see the fiat currency system showing severe signs of instability.

Whether the Hunt brothers were victims of their own greed, the greed of board members on the exchanges, a desperate attempt by the Fed to save the dollar, or some combination of these things, it’s clear to me that the fall of silver in 1980 brought gold down with it and bought the dollar some extra time.

We have no way of knowing how high gold and silver would have gone if the government and banking establishment hadn’t gone after the Hunt brothers. We’ll never know if the dollar would have survived. We do know that gold peaked when silver peaked, and we know that gold fell when silver fell.

In the near future, both of these metals may again start taking off into the stratosphere. And this time, the Fed won’t have the Hunt brothers around to stop them.

According to the ancient Greek historian Herodotus the treasure of no Egyptian pharaoh was comparable in either size or value to the enormous hoard of Rhampsinitos. His treasury was housed in a huge stone building adjacent to the palace, and it was considered burglar-proof. The door was sealed by the pharaoh's personal seal and manned around the clock by armed guards. Rhampsinitos was present in person every time the seal was broken and the building entered. Therefore it was extremely disturbing when the pharaoh discovered that his treasure was being pilfered, albeit without any sign of unauthorized entry into the building. To find out what was going on the pharaoh caused a trap to be placed inside to catch any would-be thief as he was approaching the treasure-bins. To his utter amazement, on his next visit the pharaoh found that, while the trap had done the job of catching the would-be thief, this did not help him one iota to solve the mystery. More treasure was missing, together with the head of the would-be thief. There was no sign showing how the missing objects had been spirited out of the building. The identity of the thieves could not be established. As if someone had the supernatural power to enter the building invisibly and pilfer the treasure without leaving any trace.

Pilfering the Wealth of Nations

The Great Depression seems to have presented a similar mystery. Productive enterprise came under pressure to liquidate debt and inventory, so excruciating had the debt-burden become. Those firms that could not liquidate fast enough were themselves liquidated. The Wealth of Nations was decimated as scores of firms that still flourished only yesterday were going bankrupt. There was no sign whatever that the loss of wealth might be due to plunder or pilferage. Governments purchased nostrums prescribed by Keynesian and Friedmanite soothsayers to prevent similar disasters from happening in the future in the belief that the destruction of wealth was due to natural causes. But as depression has struck Japan in spite of taking the prescription, and as other countries appear to succumb to the Japanese disease, the peddlers of nostrums are open to charges of being impostors. In the absence of an acceptable theory explaining the Great Depression the danger of future depressions looms larger than ever in the horizon.

Our revisionist view presented here for the first time suggests that, far from being due to natural causes, the Great Depression was unquestionably the result of plunder and pilferage. The Wealth of Nations was being pilfered invisibly. Those responsible couldn't be caught because the thievery involved no physical movement of property. It is no less remarkable that whenever a dead body is found (such as that of LTCM, or that of Enron), the head is missing and the investigation of theft can proceed no further. Public opinion has been lulled into the false belief by the economists' profession and by the financial media that there is in fact no pilferage, and the phenomenon must be explained by the idiosyncracies of the capitalist system of production.

Capital Consumption

It is a daunting task trying to change a consensus that has been nurtured through generations. Yet we must not shrink from exposing the crime if we know who the culprit is, even if we run the risk that our evidence will be laughed out of court. Here is our analysis. The thievery involved no physical transfer of property. It involved book-keeping transfers from the balance sheet of the productive sector to that of the financial sector. The root cause of the wholesale bankruptcy of productive firms was not the falling price structure but the falling interest-rate structure. As interest rates fell, bond prices rose, and with them rose the present value of debt. This caused the cost of servicing productive capital already deployed to rise as well. However, no allowance for increased costs was made in the balance sheet. There was no recognition of the fact that falling interest rates caused the cost of liquidating liabilities to snowball, changing the bottom line of the liability column unilaterally. In other words, there were losses that were never realized and no charges to income against them have been made. As this was the practice across the board, the failure to realize losses in the national economy meant that society has been consuming capital on a grand scale over a long period of time. In the end productive enterprise was operating on the strength of phantom capital. Not only was capital consumption universal affecting all firms engaged in productive enterprise, it was going on unnoticed. The viciousness and violence of the reaction, when it finally came, was unprecedented. Productive firms were falling right and left, regardless of the demand for their products. Firms that were certified as being sound one day would go bankrupt the next. One of the lessons of the Great Depression is that capital consumption is the most treacherous form of credit abuse that may plague society, mainly because it can go on unnoticed for so long before anyone will detect it. Corrective action, when it comes, is too late. This highlights the importance of maintaining the highest accounting standards. Any attempt at compromise is a crime not only against the shareholders, but against society as a whole.

Once we have identified capital consumption as the cause of the Great Depression, the next question is why the rate of interest was falling as long and as much as it did, making the consumption of capital on the grand scale possible. To be sure, without such a prolonged and pronounced fall the consequences of the error of omission to account for losses due to the increase in the cost of liquidation would have been inconsequential. In order to find the reasons for the fall in interest rates we have to refer to chronology. This will establish the direct responsibility of politicians, in particular, the responsibility of one man, F.D. Roosevelt. The banks in the United States lay prostrate between Election Day, November 1932, and Inauguration Day, March 1933. As a consequence of the economic boom of the "roaring twenties" interest rates were steadily rising and bank capital was greatly weakened by the proliferation of non-performing loans. Rumors had it that Roosevelt, the Democratic candidate for the presidency would, in spite of his repeated pledges during the campaign to the contrary, "go off" the gold standard and devalue the dollar. There was a run on the banks. People were withdrawing their savings before the monetary mischief could be sprung upon the nation. They didn't trust the integrity of the banks or that of the politicians — not entirely without reasons, as one might add in retrospect. Some revisionist historians even go as far as suggesting that rumors of devaluation were deliberately planted by Roosevelt himself. He did want the banks to fail so that upon inauguration he could declare a state of emergency and assume dictatorial powers. (Note that these allegations of revisionist historians have no bearing on my argument. Be that as it may, it is a fact that Roosevelt made himself unavailable during the interregnum, and refused to deny the rumors of an imminent devaluation, in spite of repeated appeals from Hoover.)

Wiping out Negative Net Worth

Shortly after inauguration Roosevelt did indeed close the banks. Later most of them were reopened and given a clean bill of health but, in reality, the banks were in a very sorry state rather similar to that of the Japanese banks today. They had a negative net worth. There were huge holes in their balance sheets. They could open for business only by virtue of the government's connivance allowing bank inspectors not to enforce the accounting rule that assets be carried at market value in the balance sheet. The banks had a strategy to wipe out negative net worth by mending the holes in their balance sheet — a Herculean task. On the assumption that interest rates would fall further, they could keep buying government bonds to let capital gains in the bond portfolio take care of capital insufficiency.

There was just one problem with that strategy. It was the risk that interest rates may turn around and start rising. This would not only hurt the banks, it would turn the bond market into a "killing field". Field where the banks would be slaughtered. There were plenty of reasons, too, why interest rates could indeed turn around and start rising again. There was the continuing threat of devaluation of the dollar. There was the added threat of a huge inflation. (In the fullness of times, both threats became a reality.) There was a flight of capital from the country. The banks could not have concocted a riskier strategy to save their skin. But there was a godsend which turned the risky bet into a safe one. The risk threatening the banks' strategy was removed by a Presidential Proclamation.

Save the Banks, Ban Gold

Roosevelt called in gold coinage and then cried down the value of the dollar. He made trading in and owning gold (in forms other than jewelry) a crime. What has all this got to do with the banks' strategy for survival? Here is the connection, which has never been adequately explained by scholarship. The risk that interest rates might turn around and rise, thus frustrating the banks' strategy to wipe out negative net worth, was eliminated by Roosevelt's ban on gold hoarding. The ban had a deflationary effect on the economy as it started a downward spiral in the rate of interest. Before the ban those who wanted to manage their liquid wealth most conservatively would park it in gold. After the ban they were forced to park it in government bonds. The captive clientele for government bonds guaranteed that bond prices would keep rising, and interest rates would keep falling, for several years to come. The banks were given the green light to go ahead with their massive bond-speculation scheme. An orgy of speculation in the bond market followed.

Everybody knows about the bull market in stocks in the 1920's. Reams of books have been written on that subject. But nobody seems to have heard about the bull market in bonds in the 1930's. Yet it is a fact that the volume of the latter surpassed that of the former by a factor of ten. The banks made obscene profits in the form of capital gains in the bond portfolio. For the next six years, while interest rates continued to fall, the banks and other firms in the financial sector got fabulously rich while firms in the productive sector were being put through the wringer. The banks' profits were more than enough to wipe out negative net worth. Banks that had been technically bankrupt at the beginning of the decade were in ultra-strong financial position by the end of the same decade.

Financial Vampirism

The banks' newly found wealth did not come out of nothing. It was not newly created wealth. It was existing wealth that was siphoned off the balance sheet of productive enterprise forcing it into bankruptcy in consequence of this financial vampirism. We must remember that the banks' pilfering the Wealth of Nations was made possible in the first place by the crudest form of government intervention in the market: the confiscation of the people's gold without due process, something the government was not authorized to do under the Constitution. The unconstitutional act was the catalyst to bring about the historic fall in the interest-rate structure. This is not to suggest that Roosevelt was an accomplice or a stooge, nor that he declared his ban on gold hoarding for the purpose of bailing out the banks. It is possible that he had other motifs, and the benefit to the banks was a fortuitous coincidence. We may never know, and it does not matter. The fact remains that tampering with gold is tantamount to tampering with interest rates. It is a most dangerous expedient as it may have many unforeseen and untoward consequences. Far from being a barbarous relic, gold remains firmly implanted at the base of the credit pyramid. Gold has been removed from the economy only in the visionary view of revolutionaries.

This, then, is the revisionist view of the Great Depression. Without the gold ban the recession that started with the 1929 stock market crash would have been over by 1932. With the gold ban, the recession was turned into the greatest depression of all times. The man who was celebrated as savior ridding the nation of the curse of depression was in fact the one who had brought about the disaster in the first place. He pulled the gold trigger releasing the murderous forces of bond speculation to prey upon the productive sector. It heralded the continuing fall of the rate of interest. Bond speculators, first and foremost the banks among them, were ready to move in for the killing. The vultures picked the bones of productive enterprise clean. All this was done under the veil of anonymity. Nobody could have guessed that the Great Depression was a happy time for some. Well, for the bankers it was time for popping corks. Not only was their skin saved, but they became so strong financially that they could thereafter dictate government policy.

Amend the Criminal Code!

The Criminal Code does not deal with theft perpetrated through siphoning off wealth stealthily from someone else's balance sheet through the manipulation of the interest rate structure. This in itself is understandable as it has been drawn up before the techniques of such manipulation were developed. But why has the government failed to amend the Criminal Code to deal with new forms of crime against private property as soon as the new techniques to commit them were developed? Is it pursuant to a pact representing conspiracy between the government and the banking fraternity, the foremost beneficiary of the new forms of crime? Where have the accountants and the economists been to demand a public inquiry into these questions?

There are many cases where the development of technology creates new possibilities to invade and pilfer the property of others in various ways not dealt with by the Criminal Code. All these cases exhaust the common-sense concept of thievery as they are guided by the intention of securing an advantage at the expense of the invaded party. And, indeed, in all these cases the Criminal Code has been amended soon after the new technology to commit the crime of thievery was developed. One example is the invention of saleable electric power. Understandably, the original Criminal Code could not deal with the invisible crime of stealing electric power. The technology of committing the crime was not yet available at the time. Yet soon enough after the introduction of marketing electric power the Criminal Code was amended to cover all new forms of crime connected with the unauthorized tapping of electric power, including the wired and the wireless variety. It is the scandal par excellence of the past century and millennium that no amendment to the Criminal Code has ever been proposed to deal with the biggest invisible crime of all: that of the unauthorized tapping of the balance sheet of productive enterprise — a crime made possible by the destruction of the gold standard and its corollary, the manipulation of interest rates through central-bank open market operations and bond speculation.

Don't Entrust Your Money to Desperadoes

We have seen that the chief culprit and the only beneficiary of the Great Depression was the banking fraternity. They profited from the disaster devastating the world economy. Let's pick up the thread left off in part two, and continue our discourse on the consequences of relaxing accounting standards and allowing illiquid banks to keep their doors open for business. An illiquid bank, by definition, is one that can be considered solvent only by virtue of relaxing accounting standards, allowing the bank to carry an asset (usually a government bond) at acquisition price, regardless how low the current market price of that asset may have fallen. It was a colossal mistake to reclassify insolvent banks as merely 'illiquid' and letting them continue in business. Why? Well, illiquid banks are desperadoes ready to take unreasonable risks with the people's money entrusted to their care. Illiquid banks have nothing to lose but their stigma of being insolvent. They should be closed down by bank inspectors without hesitation. Any compromise in relaxing accounting standards is foolish in the extreme. It invites great dangers affecting not only shareholders and depositors, but society as a whole. It is hard to imagine a dictum more insane than the one: "Bank X is too big to fail". The bigger the insolvent bank, the greater is damage that it will ultimately inflict on the unsuspecting productive sector.

Cui bono?

We have argued that the Great Depression of the 1930's was caused by illiquid banks in the United States as they became the engine of an unprecedented speculative orgy in the bond market in order to drive down interest rates. We could also argue that the present depression in Japan has been caused by the large insolvent Japanese banks as they have become the engine of another enormous bull market in bonds to drive the rate of interest to zero. There is more to this story than revisionist history. Our insight may help explaining the passing scene of our days. The ban on gold hoarding has been replaced by the manipulation of the gold market, possibly with government connivance. In trying to understand an unexpected or puzzling event, historians used to ask the key question: cui bono? (who is the possible beneficiary?)

It ought to be understood well that gold manipulation (i.e., conspiracy to keep the price of gold permanently in a low range) is deflationary. Just as Roosevelt's ban on gold hoarding, the present exercise in gold manipulation also has the effect of restricting demand for physical gold. The result is the same: interest rates keep falling, and for the same reasons. Liquid capital all over the world is seeking out the 'next best' alternative to gold as a conservative investment medium. It will find it in the form of U.S. government bonds. Once more, a captive market for bonds has been created. As the bidding continues, interest rates keep falling. Bond speculators are invited to jump on the bandwagon. The risk that interest rates might turn around and start rising, thereby frustrating the speculation, has been greatly reduced by the gold manipulators. Before our very eyes (and not everyone has eyes to see this sort of thing) there is an orgy of bull-market speculation in bonds. It started twenty years ago. The end may not be in sight yet. In 1980, interest rates in the United States were around 16 percent per annum. They have come down to the level between 4 and 5 percent. If the example of Japan is any guide, they still have a long way to go. American interest rates could follow the Japanese into the abyss. Why not? The mechanism to link the two rates is already in place. It is called the yen-carry trade. The speculator sells the Japanese bond and buys the American. This amounts to borrowing yens at zero percent (or thereabouts), converting the proceeds into dollars and lending them at 5 percent. The reward? Almost 5 percent — not bad for shuffling paper. Clearly, the effect of the yen-carry trade is to drive down the rate of interest in America, too.

The consequences of a falling interest-rate structure today are no different from those in the 1930's. There is capital consumption in the productive sector. There is a clandestine transfer of wealth from the productive to the financial sector. Cui bono? Why, for the benefit of the banks, of course. American and Japanese banks. Banks of any stripe or color. The worst part of it all is that the public is still in the dark about the invidious consequences of falling interest rates. It is being told a tale about free markets deciding bond values and the value of gold. The ominous fact, however, is that both markets are rigged to the core. They are like a casino where the dice are loaded for the benefit of the house.

$100 trillion worth of hot air

The truth is that there is no public benefit in bond, foreign exchange, and gold speculation. None whatsoever. The world could still go on without any of this trading, and no one would be any worse off. The overwhelming majority of the people, including all savers and producers, would be better off. Interest and foreign exchange rates were so stable under the regime of the gold standard that no speculator in his right mind would hold bonds or foreign exchange in the hope of speculative gain. Not only do we have speculation in bonds and foreign exchange, we have also allowed speculators to construct derivatives markets on the top of the bond, foreign exchange, and gold markets. Since 1971, the combined volume of derivatives has snowballed as it has hit and surpassed the $100 trillion mark! No misprint here. There is commitment to pay compensation for the fluctuation in the value of $100 trillion worth of paper. (Never mind that there isn't as much paper in existence, not even if we include the scum of the junk bond market.) For centuries before 1971, the grand total of paper so 'insured' was exactly zero. To put it differently, in 1971 the world all of a sudden developed an insatiable appetite for insurance. In thirty years the world has come up with $100 trillion worth of 'insurables' to bolster security. What security? Maybe financial security? No, we can't very well say that, not after the collapse of Enron, and not after the dollar having lost an unprecedented 90 percent of its purchasing power during the same thirty years. Then physical security, perhaps? No, not physical security. Not after the destruction of the twin towers of the World Trade Center, and not in the middle of a drama in two acts, the oil war against Iraq. Then what kind of security is it that the insuring of $100 trillion represents? Search as you may, you will find but hot air. The world was a much better and safer place for hundreds of years with stable interest and foreign exchange rates, and with a stable gold price, and without any insurance on hot air. Had it kept them that way, it could have earmarked funds for the eradication of poverty, hunger, diseases, illiteracy, or for any other noble cause.

The $100 trillion dollar market in derivatives created by the big American and Japanese banks serves no purpose consonant with the interest of the national or world economy. It serves one purpose only: the aggrandizement of the profits of the financial sector at the expense of the productive sector. The big American banks were as insolvent twenty years ago as the Japanese banks are today. Then they started their desperate bond-market gamble, trying to drive down interest rates. They badly needed capital gains in their bond portfolio to mend the enormous holes in their balance sheets. The gamble has paid off. Today the American banks are in a better financial shape than twenty years ago. However, a high price for saving their skin was paid by the productive sector. American firms producing hardware have been put out of business. Solid jobs in the productive sector were eliminated and replaced by soft jobs in the service sector. The plight of the American breadwinner who is now flipping hamburgers instead of pouring molten steel (and who may soon be out of any job) is in direct consequence of the orgy in bond speculation. Nor is this all. The depression in Japan may not stop at the Pacific. It may well portend to engulf America and the rest of the world.

Bond Speculation is No Zero-Sum Game

I am well aware that the sum $100 trillion is a 'notional' amount. We are not talking about $100 trillion worth of bonds being traded. We are talking about the combined stakes of bond speculators who have placed bets on the rate of interest, and want to profit as if they have owned bonds in that amount. But the profits, provided the speculators' bet comes off, are not 'notional'. They are payable in cold cash. Suppose for the sake of argument that these bets call for lower interest rates on a net basis. In other words, most speculators would be buyers of bonds as they expect their value to rise further. (This is a plausible assumption. No doubt this is exactly what Japanese banks scrambling to get out of bankruptcy are likely to be doing right now.) If interest rates did in fact go down and the price of bonds did go up, say 1 percent, then the speculators' profit would be $ 1 trillion in cash. Who is going to pay that?

Economists will tell you that the profit of one speculator is the loss of another. Don't buy that. It is arrant nonsense. It would be true only if bond speculation were a zero-sum game, which it is not. It would be true only for stabilizing speculation dealing with risks created by nature, for example, in the futures markets for agricultural commodities. Here speculators make money by resisting the formation of price trends. As there can be no consensus about the question whether the formation of an uptrend or a downtrend is more likely, speculators will be betting on either side of the market. But in markets where risks are man-made, speculation is not a zero-sum game. This is the case of destabilizing speculation. In the market for bonds and its derivatives speculators make money by inducing and then riding price trends. They are on the same side of the market (which is practically always the winning side). Remember, speculators can influence the outcome by throwing their weight around. (Try to do that against the blind forces of nature!)

Why are the risks in the bond market man-made? Because under the gold standard interest rates were stable. There was little risk that bond values might change abruptly. Risks were injected artificially when politicians forcibly removed the gold standard.

But if the gains of one bond speculator is not paid by another, then who is paying it? This is a crucial question that deserves a careful answer. The other side of the bet of the bull speculator in bonds was taken by a banker for hedging rather than speculative purposes. He sold the bond in order to hedge his exposure in lending money to productive enterprise. He is not betting: he is taking out insurance, as it were, against the risk that interest rates might rise before his loan matures. With regard to the bond market, his position is neutral. He has a straddle: the loss on one leg is canceled out by the gain on the other. The loss connected with falling interest rates is passed on to the party on the other side of the hedging banker's straddle. Therefore, ultimately, the losers paying the $ 1 trillion profit to bond speculators are the firms in the productive sector. They are sitting ducks in this speculative game. They have no choice. They must carry the risk of owning productive capital, without which there will be no consumer goods for you, for me, or for any other member of society. The foregoing argument is a convincing demonstration of the mechanism whereby the capital of the productive sector is surreptitiously siphoned off to benefit the financial sector, as speculators drive down the rate of interest to zero. Producing firms are condemned to bankruptcy for the benefit of parasites. This is the essence of depressions.

Monument to Folly

The $100 trillion derivatives market is a monument to the folly of man. Derivatives trading serves no purpose other than benefiting a parasitic class, that of the bond speculators, first and foremost the banking fraternity, at the expense of the productive sector. Producers meekly accept their role of sacrificial lamb. They do so because they lack understanding of what is happening to them, just as lambs herded in the slaughterhouse do.

This exposes the enormity of the folly of having destroyed the gold standard, cutting the interest-rate structure adrift. Thereafter bond speculators would, whenever the opportunity presented itself, drive down the rate of interest all the way to zero while, in the best tradition of vampires, they suck the life-blood out of the producers. The opportunity first presented itself in 1933 when Roosevelt banned gold hoarding, making the one-sided speculation in bonds possible. A new opportunity seems to present itself right now, as a result of a new phenomenon, the gold-carry trade. Its real purpose is not so much the capping of the gold price as the making the one-sided bond speculation possible once more. Thus the gold-manipulation scheme serves as a foundation for the $100 trillion monument. This ought to be our reminder that bond speculators are hell-bent to plunge the world into a depression once again, as they did in the earlier episode.

Unless governments can muster their brain- and will-power, demolish that monument, stop the deadly game, and stabilize interest rates once more by opening the Mint to gold.

Note:

— This paper is based on a series of talks with the same title given by the author at Sapientia University, Kolozsvár (Cluj-Napoca), Romania, in April, 2002.

References:

— Benjamin M. Anderson, The Financial History of the United States (originally published in 1949), Liberty Press, Minneapolis

One of the plays of George Bernard Shaw branded "unpleasant" by the playwright himself is entitled The Doctor's Dilemma. The protagonist is a physician who comes into conflict with the Oath of Hippocrates (fl. 460-377 B.C.) He has developed a new treatment for a fatal disease, but the number of volunteers for the test-run exceeds by one the number of beds in his clinic. Unwittingly, the doctor finds himself in the role of playing God to decide who shall live and who shall die.

By the same token Shaw could have written the 'most unpleasant' play of them all entitled The Book-Keeper's Dilemma. In it the protagonist, a chartered accountant, finds himself in conflict with the norms and rules of book-keeping as set out by Luca Pacioli (fl. 1450-1509). Our book-keeper was willing to compromise the high standards of the accounting profession. Beforehand the question "how much is two times two?" was categorically answered "four". Now, creative accounting would respond: "how much do you want it to be?" Our book-keeper dropped a snowball that caused an avalanche, ultimately destroying Western Civilization down in the valley.

Luca Pacioli taught mathematics at most universities of Quattrocento Italy including those of Perugia, Naples, Milan, Florence, Rome, and Venice. In 1494 he published his Summa Arithmetica. Tractatus 11 of that work is a textbook on book-keeping. The author shows that the assets and the liabilities of a firm will exactly balance out, provided that we introduce a new item in the liability column that has been variously called by subsequent authors "net worth", "undivided surplus", "shareholder equity" or, simply, "capital". This innovation makes it easy to check the ledger by finding that, at the close of every business day, assets minus liabilities is exactly equal to zero. If it is not, then there is an error somewhere in the books. But what Pacioli discovered was something far more significant than a method to find errors in the arithmetic. It was the invention of what we today call double-entry book-keeping, and what Goethe has called "the finest product of the human brain" (cf. Wilhelm Meister's Apprenticeship).

Why was this discovery so important in the history of Western Civilization? Because, for the first time ever, it was possible to calculate and monitor shareholder equity with precision. This is indispensable in starting and running a joint-stock company. Without it new shareholders couldn't get aboard and old ones could not disembark safely. Nor would stock markets, mergers, acquisitions be possible. The national economy would be a conglomeration of cottage industries quite unable to undertake any large-scale project such as the construction of a transcontinental railroad, or the launching of an intercontinental shipping line. The invention of the balance sheet did to the art of management what the invention of the compass did to the art of navigation. Seafarers no longer need to rely on clear skies in order to keep the right direction. The compass has made it possible for them to sail under cloudy skies with equal confidence. Likewise, managers no longer have to depend on risk-free opportunities to keep their enterprise profitable. The balance sheet tells them what risks they may take and which ones they must avoid. It is no exaggeration to say that the present industrial might of Western Civilization rests on the corner-stone of double-entry book-keeping. Oriental (Chinese) or Middle-Eastern (Arab) Civilizations would have outstripped ours had they chanced upon the discovery of the balance sheet first.

Barbarous Relic or Accounting Tool?

For the past 70 years the world has been fed the propaganda-line, due to Keynes, that the gold standard is a "barbarous relic" long since ripe to be discarded. The unpleasant truth, one that propagandists have forgotten to mention, is that the gold standard is merely a proxy for sound accounting (as well as moral) principles. Nor was it the gold standard per se that politicians wanted to overthrow. Certain accounting and moral principles had become an intolerable fetter upon their ambition for aggrandizement and perpetuation of power. Historically these principles had been singled out for discard before the gold standard was given the coup de grâce. The first successful attack on accounting standards was heralded by the establishment in 1913 of the Federal Reserve System, the engine for monetizing government debt. Just how this has led to a hitherto unprecedented, even unthinkable, corruption of accounting standards — this is a question that has never been addressed by impartial scholarship before.

The Rate of Interest and the Wealth of Nations

In order to see the connection we must recall that any durable change in the rate of interest has a direct and immediate effect on the value of all financial assets, just as tides and ebbs have on the level of boats anchored in the harbor. Rising interest rates make the value of bonds fall, and vice versa. But while a rise makes the Wealth of Nations shrink and a fall in the rate of interest makes it expand, the benefits and penalties are distributed capriciously and indiscriminately, without regard to merit. This was hardly disturbing under the gold standard as the rate of interest was remarkably stable and changes in the Wealth of Nations were negligible. A lasting increase in interest rates could only occur in the wake of a national disaster such as a flood, earthquake, or war. In all these cases higher interest rates were beneficial. They had the effect of spreading the loss of wealth due to the destruction of property more widely. Those segments of society that were lucky enough to escape physical destruction still had to take their share in the loss through the increased cost of servicing capital due to the higher rate of interest payable on future borrowing. Everybody was prompted to work and save harder in order that the damage might be repaired more quickly and expeditiously. As interest rates gradually fell back to their original level, the Wealth of Nations expanded. Again, benefits were shared in the form of reduced cost of servicing productive capital on future borrowing. It is not widely recognized that the eminence of the gold standard is not to be found in a stable price structure (that is neither possible nor desirable) but in a low and stable interest-rate structure maximizing the Wealth of the Nations, ruling out capricious and disturbing swings in it. The gold standard, which was taken for granted before World War I, was put at risk once general mobilization was ordered in 1914 by the manner in which belligerent governments set out to finance their war efforts. They wanted to perpetuate the myth that the war was popular, and there was no real opposition to the senseless bloodshed and destruction of property that could have been prevented through better diplomacy. The option of financing the war effort through taxation was discarded as it would make the war less popular. The war had to be financed through credits. In more details, war bonds were to be issued in unprecedented amounts, subsequently monetized by the banking system. Naturally, these bonds could not possibly be sold without a substantial advance in the rate of interest. Accordingly, the Wealth of Nations was shrinking even before a single shot was fired or a single bomb dropped.

Tormenting Widows and Orphans

Under the gold standard bondholders are protected against a permanent rise in the rate of interest (which in the absence of protection would decimate bond values) by the provision of a sinking fund. In case of a fall in the value of the bond, the sinking fund manager would enter the market and keep buying the bond until it was once more quoted at par value. Significantly, sinking fund protection was offered by every self-respecting firm issuing bonds. Even though governments as a rule did not offer it, it was understood and, in the case of the Scandinavian governments explicitly stated, that if a permanent rise in the rate of interest occurred, then the entire bonded debt of the government would be refinanced at the higher rate. Bondholders who had put their faith in the government would not be allowed to suffer losses. The banks, guardians of the people's money, could regard government bonds as their most trusted earning asset. Such faith, at least in the case of Scandinavian government obligations, was justified. The risk of a collapse in bond values was removed. Governments, at least those in Scandinavia, occupied the moral high-ground. They had borrowed money which, in part, belonged to widows and orphans. They took to heart the Biblical admonition. They did not want to bring upon themselves the curse pronounced on the tormentors of widows and orphans.

The Law of Assets

But there was a problem with war bonds issued by belligerent governments. These bonds were quickly monetized by the banking system making the refinancing of bonded debt impossible. This created a dilemma for the accounting profession. According to an old book-keeping rule going back to Luca Pacioli that we shall here refer to as the Law of Assets, an asset must be reported in the balance sheet at acquisition price, or at the market price at the time of reporting, whichever is lower. In a rising interest-rate environment the value of all financial assets such as bonds and fixed-rate obligations are falling, and the fall must be faithfully recorded in the balance sheet. There are excellent reasons for this Law. In the first place, it is designed to prevent credit abuse. Without it banks and other lending institutions could easily overstate the value of their assets — an invitation to reckless use of credit to the detriment of shareholders and depositors. If the abuse went on for a considerable period of time, then it could lead to the downfall of the bank. In an extreme case when all banks disregarded the Law of Assets, the banking system could be operating on the strength of phantom capital and a general credit collapse might be the result. For non-banking firms the possibility of overstating asset-values also exists, and could likewise serve as a temptation for financial adventures. Even if we assumed that upright managers would always resist it and would not knowingly get involved in such adventures, in the absence of the Law of Assets the balance sheet ceased to be a reliable compass to guide the firm, materially increasing the chance of making an error. Managerial errors would compound, and the result could again be bankruptcy.

Economists of a statist persuasion argue that an exception to the Law of Assets could safely be made in case of government bonds. The government's credit, like Caesar's wife, is above suspicion. The government's ability to retire debt at maturity cannot be doubted. As a guarantee, these economists point to the government's power to tax, as well as to its power to collect seigniorage. However, the problem is not with paying the nominal value of government bonds at maturity, but with its purchasing power. Currency debasement is a more subtle and hence more treacherous form of default. The government, however powerful, cannot create something out of nothing any more than an individual can. It cannot give to Peter unless it has first taken it from Paul. Nor is the taxing power of the government absolute. Financial annals abound in cases where taxpayers revolted against high or unreasonable taxes, thereby causing the overthrow of government and forcing the cancellation of bonded debt. If the taxing power of the governments had been absolute, then World War I could have been financed out of taxes and no loss of purchasing power to bondholders through debt-monetization would have occurred.

A strict application of the Law of Assets would have made most banks and financial institutions in the belligerent countries insolvent. The dilemma facing the accounting profession was this. If accountants insisted that the Law be enforced, then they could be considered "unpatriotic", and be held responsible for the weakening financial system of the country. Demagogues could charge that the accountants were undermining the war effort. On the other hand, if they allowed the banks to report government bonds in the asset column at acquisition-value rather than the lower market value, then they would compromise the time-tested standards of accounting and expose the firm, and the economy, to all the dangers that may follow from this, not to mention the fact that they would also bring the credibility of their profession into question.

Insolvent or Illiquid?

The story of how the accounting profession solved the dilemma has never been told. It appears a safe assumption that the dilemma was solved for it by the belligerent governments themselves through secret directives making it clear that public disclosure of the banks' true financial condition would not be tolerated. Nor could a public discussion of the subtle changes in accounting theory, following those in accounting practice, be entertained. These included the throwing of the Law of Assets to the winds, replacing it with a new and more relaxed one allowing the banks to carry government bonds in the asset-column at acquisition value, regardless of true market value, as if it were a cash item. A new term was introduced in the dictionary to describe the financial condition of the bank with a hole in its balance sheet, provided that it could still meet the new relaxed criteria for solvency. Such a bank was henceforth called "illiquid". We shall see later why the practice of allowing illiquid banks to keep their doors open is a dangerous course to follow, as it has far-reaching consequences threatening, as it does, the very foundations of Western Civilization. (The recent scandal involving the American giant Enron is in fact a scandal involving not just one accounting firm as alleged, but the entire profession. In the final analysis, the scandal has its origin in the unwarranted relaxation of accounting standards back in 1914, which has never since been rectified.)

I am in no position to prove that a secret gag-rule was imposed on accountants. But I am at a loss to find an explanation why an open discussion of the wisdom of changing time-honored accounting principles has never taken place. Apparently there were no defections from the rank and file of the profession denouncing the new regimen as unethical and self-defeating. These underhanded changes in accounting standards have opened the primrose path to self-destruction. The dominant role of Western Civilization in the world was due to the moral high-ground staked out by the giants of the Renaissance, among them Luca Pacioli. As this high-ground was gradually given up and the commanding post was moved to shifting quicksand, and as rock-solid principles gave way to opportunistic guidelines, Western Civilization has been losing its claim to leadership in the world. It should come as no surprise that this leadership is presently facing the most serious challenge of its entire history.

The chickens came home to roost in 1921 when panic swept through the U.S. government bond market. Financial annals fail to deal with this panic (exception: Benjamin M. Anderson's posthumously published Financial History of the United States). Nor was it given the coverage in the financial press it deserved. Information was confined to banking circles where the panic hit hardest. Clearly, it was in the interest of the government and the banks to hide the news under the bushel. There was an unprecedented peace-time jump in long-term interest rates, causing devastation in the market for long-term U.S. government bonds. Upright bankers looked at bond quotations in disbelief and desperation. The strongest pillars of their balance sheet were subjected to an unprecedented meltdown, taking place before their very eyes.

The crisis of 1921 was swept under the rug as the Federal Reserve banks stepped in the breach and shored up the balance sheet of their member banks. An historic opportunity was missed to mend the ways of the world that had gone astray in 1914. It was the last opportunity to avert the Great Depression, already in the making.

The Law of Liabilities

Purely by using a symmetry-argument we may formulate another fundamental principle of accounting, the Law of Liabilities. It states that a liability must be reported in the balance sheet as the amount(s) payable at maturity, or as the amount that would liquidate it at the time of reporting, whichever is higher. Since liquidation must take place at the current rate of interest, in a falling interest-rate environment the liabilities of all firms are rising. The possibility of a simultaneous rise in the liabilities of all productive firms represents a great danger to the national economy. This danger has been disregarded by the economists' profession, an error of omission that ought to be rectified without any further delay. This is in fact that the present paper has set out to do. As we know, mainstream economists failed to raise their voice against the folly of cutting the interest-rate structure adrift and letting it fluctuate for reasons of political expediency — implicit in both Keynesian and Friedmanite nostrums. Is it possible that the reason for this failure was the fatal blind spot mainstream economists appear to have with regard to the danger of overestimating national income in a falling interest-rate environment?

The proposition that a firm must report liabilities at a level higher than what is due at maturity whenever the rate of interest falls is, of course, controversial. Let us review the reasons for this crucial requirement. If the firm comes up for liquidation then, of course, all liabilities become due at once. Sound accounting principles demand that sufficient capital be maintained to make liquidation without losses possible at all times. If interest rates were to fall, then clearly earlier liabilities had been incurred at a rate higher than necessary. For example, if an investment was to be financed through a bond issue or a fixed-rate loan, then better terms could be secured by postponing it until the lower rate would become available. In other words, making the investment earlier was a managerial error of timing. This is a world of crime and punishment, and even the slightest error brings a penalty in its train. The increase of liability in the balance sheet is just the penalty for that managerial error. Even if the investment has been financed out of internal resources, penalty is still justified. Alternative uses for the resource would have brought better financial results.

But let us assume that the investment was absolutely necessary to make at the time it was made. There was no managerial error of timing. At any rate, we absolve management of all responsibility in this regard. The case for an increase in liability still stands. After all has been said and done, there still is an obvious loss due to the fact that servicing investment must be made at a rate higher than that available in the market. This loss ought to be realized if we want the balance sheet to continue to reflect the true financial position. Any other approach would create a fools' paradise. To see this more clearly we may point out that these losses are analogous to the ones due to an accidental fire destroying physical capital not covered by insurance. The loss still has to be realized as it is absolutely necessary that the balance sheet reflect the changed financial picture caused by the fire. If the loss was small enough, it could be charged directly to shareholder equity. But in the case of larger losses shareholder equity may not be sufficient for the purpose. In this case (the remaining part of) the loss will have to be charged against future earnings. The proper way to go about it is a three-step adjustment as follows:

(1) Create an entry in the asset-column called "fund to cover fire loss".

(2) Create an equivalent entry in the liability-column.

(3) Amortize the liability through a stream of payments out of future income.

It is clear that if the accountant failed to do this, then he would falsify future income statements. As a result, losses may be reported as profits, or phantom profits may be paid out in the form of dividends. Not only would this weaken the financial condition of the firm, but it would also render the balance sheet meaningless. As this might lead to further errors, losses would be compounded.

Exactly the same is true if the loss was due not to fire but to a fall in the rate of interest. The way to realize the loss is analogous. For a larger fall in the rate of interest shareholder equity may not be large enough to cover the corresponding loss. In this case a new entry must be created in the asset-column called "fund to cover overpayment in servicing capital, made necessary by a fall in the rate of interest", against the creation of an equivalent entry in the liability column, to be amortized by a stream of payments out of future income. This is not an exercise in pedantry. It is the only proper way to realize a real loss which has, I repeat, been incurred as a result of the inescapable increase in the cost of servicing productive capital already deployed in the wake of a fall in the rate of interest. Ignoring that loss would not erase it, while it might certainly compound it.

The Historic Failure to Recognize the Law of Liabilities

I anticipate a torrent of criticisms asserting that there is no such a thing as the Law of Liabilities in accounting theory and practice. I submit that I have no formal training in accounting, nor have I made an independent study of the theory and history of accounting. I am not able to provide reference to original sources to which the Law of Liabilities could be traced. (By contrast, the Law of Assets appears in several older textbooks that have long since been discarded by practicing accountants as well as professors of accounting.) But I shall argue that either Law follows the spirit, albeit, perhaps, not the letter of Luca Pacioli. Affirming one while denying the other makes no sense. Every argument that supports one necessarily supports the other. There is a perfect logical symmetry between the two Laws, arising out of the symmetry of assets and liabilities in the balance sheet. Ignoring either Law is a serious breach of sound accounting, possibly with extremely grave consequences. For example, if the rate of interest keeps falling for an extended period of time, as it has in Japan for almost a decade now, then present (in my opinion, deeply flawed) accounting standards will allow losses to be reported as profits. The resulting wholesale capital destruction, which the country may not realize until it is too late, could bring the national economy to its knees spelling depression, deflation, or both (as it seems to be occurring in Japan right now).

Even if the fact could be established that the Law of Liabilities has never been spelled out in any official accounting code going back all the way to that of Luca Pacioli, we should still not jump to the conclusion that there is no justification for it. A convincing argument can be made explaining why this Law might have escaped the notice of upright and knowledgeable accountants in the past, with the consequence that the Law has never been codified.

We couldn't blame Luca Pacioli if he had failed to foresee the level of duplicity and bad faith displayed by the politicians and bankers of the twentieth century. In particular, I refer to the affront represented by the act of calling in gold coinage and then writing up its value — all to the detriment of the people (as it was done in the United States in 1933). He had lived before any central bank was established. It is a pity that Luca Pacioli failed to anticipate the chicanery of open market operations for the purpose of manipulating interest rates to political ends. If he had, he might have been able to warn us of the danger of the coup in which the sorcerer's apprentice grabbed the initiative from the sorcerer with the consequence that interest rates could be driven down to zero in order to bleed white the saving and producing segment of society. But Luca Pacioli firmly believed in upright business deals and honorable dealings between the government and the people. The chicanery of gold manipulation would have appeared incredible to him, as if it had belonged to the realm of phantasy. Without gold manipulation, the only way for the rate of interest to have a prolonged fall could occur only if savers continued to save despite the fall. Even then, the fall in the rate of interest would be so gradual that no producer would be hurt by it. A decline from 15 to 5 percent per annum (as occurred in the United States during the past twenty years) would have been impossible. No wonder that Luca Pacioli did not provide for such an eventuality in his code of accounting standards!

In the 1930's agitation against the gold standard started in earnest. Britain abandoned the gold standard in September, 1931, and the United States, in March, 1933. The last obstacle removed, the door to suppressing the rate of interest to political ends through open-market operations was thrown wide open. Bond speculators, especially the banks, were electrified by the undreamed-of opportunity to become rich without shouldering any countervailing risk. As a result of government monetary policy and private bond speculation interest rates were falling throughout the 1930's. The size and the rate of the fall were unprecedented. The world was unprepared for a revolution of such proportions, potentially greater than the subversion of the national economy in Bolshevik Russia barely a decade earlier. The world was lacking an accounting code to cope with the unprecedented across-the-board increase in liabilities that hit the productive sector as a consequence of the confiscation of the people's gold by a government supposedly standing for private property and sanctity of contracts.

Falling Interest Rates Squeeze Profits

Here is a paradox. Falling interest rates squeeze the profits of productive enterprise. This is paradoxical since the general consensus is that lower interest rates are salubrious to business. In truth, however, fluctuations in either direction hurt. Higher rates make the cost of servicing future investment soar, while lower rates do the same with regard to past investments. Recall that the reason for the latter is that the present value of debt rises. As it does, the cost of liquidating liabilities goes up. This creates a loss which ought to be a charge against future earnings.

Some of my critics, while agreeing that losses occur in the liability column, would argue that these are offset by gains in the asset column. Falling interest rates increase the present value of future earnings, thus increasing the value of assets. The trouble with this argument is that it ignores the Law of Assets which does not allow putting values on assets higher than historic cost, regardless of any expected increase in future earnings. As the proverb says, "there is many a slip between cup and lip". Unforeseen liquidation of the enterprise would reduce all future earnings to zero. The book-keeper has no choice but to charge the increased cost of liquidation unilaterally to the liability column.

The capitalist system has lifted mankind out of mass poverty. It is this system that in the last century and in the last generation, has progressively changed the face of the world, and has provided the masses of mankind with amenities that even kings did not posses or imagine a few generations ago. - Henry Hazlitt

The American people will never knowingly adopt socialism. But, under the name of “liberalism”, they will adopt every fragment of the socialist program, until one day America will be a socialist nation, without knowing how it happened..I no longer need to run as a Presidential Candidate for the Socialist Party. The Democratic Party has adopted our platform. - Norman Thomas

So long as the people do not care to exercise their freedom, those who wish to tyrannize will do so; for tyrants are active and ardent, and will devote themselves in the name of any number of gods, religious and otherwise, to put shackles upon sleeping men. - Voltaire, 1764